A Revenue Revives

Left for dead, corporate income taxes are making an unexpected
contribution to state income.

Not so long ago, the corporate income tax was fading away as a source of state revenue. In 2002, soon after the end of the last recession, a Rockefeller Institute paper announced the "Collapse of the Corporate Income Tax." A 2003 report by the Multistate Tax Commission said corporate tax sheltering was costing states as much as $12 billion. The same year, Governing's special issue on taxes declared that "corporate income taxes belong on the endangered species list."

But something funny happened on the way to the grave. Three years ago, corporate income tax collections began rising and are now soaring in almost every state.

Why the surge? The bulk of the explanation comes straight from the ups and downs of the economy. Volatility has always been a hallmark of the corporate income tax, because collections tend to rise and fall with the whims of the business cycle. That cycle bottomed out a few years ago. Today, it may be hitting its apex. On its way, corporate profits rose. They bolted up 13 percent in 2004, 16 percent in 2005 and 24 percent in the first quarter of 2006, and taxes reflect that growth.

But there's more to the surge than that. In the past few years, many states closed avenues for evading taxes through so-called "tax planning." More than a dozen states passed "add-back" statutes aimed at preventing corporations from sheltering income in low-tax states such as Delaware. Other states, including Kentucky, New Jersey and Ohio, adopted gross receipts taxes that require businesses to pay something even if they're otherwise able to pencil their tax down to zero.

At the same time, businesses have become less aggressive about tax planning for other reasons. In the wake of Enron's collapse and other corporate scandals, corporations appear to be taking a better-safe- than-sorry approach to reporting their profits. Joe Huddleston, executive director of the Multistate Tax Commission, gives some of the credit to new accounting requirements in the federal Sarbanes-Oxley law. "Sarbanes has, at least over the short term, required a level of transparency in corporate transactions that we've never seen before," Huddleston says. "The result is that revenues in a lot of states have gone up."

Still, there's plenty of reason for states to curb their enthusiasm. Even with the current explosive growth, corporate income taxes make up only 6 percent of state revenues. That's down from about 10 percent in the late 1970s. States have a continuing penchant for giving huge tax breaks to certain industries or particular companies--calculated acts of generosity that are intended to create jobs but nevertheless erode the tax base.

Meanwhile, state and local officials are warily watching a bill in the U.S. Congress that aims to clarify when a company is considered to have nexus in a state for tax purposes. It would, in effect, re-open state tax loopholes for business. "It would call into question some of the add-back statutes that have been enacted," says Harley Duncan, executive director of the Federation of Tax Administrators. "It really sets up a situation where, with some aggressive tax planning, you could work your way around any corporate tax liability at all."